Our Take on the Third Quarter

By Jeremy Glaser with Morningstar

Investors hoping for a sleepy summer were deeply disappointed in the third quarter. Sovereign debt woes and concerns about the strength of the economy sent the market on a wild ride that at times resembled the volatility of the financial crisis in 2008.

Sovereign debt and deficits dominated the headlines through much of the quarter. In the United States, a heated battle over raising the debt ceiling led the nation to the brink of default. A last-minute deal averted the immediate crisis as both sides agreed to create a bipartisan congressional committee to consider ways to balance the budget and bring down the deficit. Despite the deal, Standard & Poor's downgraded the United States' sovereign debt rating to AA+ from AAA.

But in many ways the real action was in Europe. Successive plans to stem the sovereign debt crisis and contain it to peripheral Eurozone economies failed to soothe investors. Worries that the problems could lead to bank failures, or to the end of the euro altogether, sent shares of French and other European banks plummeting and credit spreads on sovereign debt soaring. Coordinated central bank intervention, continued promises from leaders that they are wiling to act, and another around of Greek austerity measures calmed markets somewhat toward the end of the quarter. But there remain many outstanding questions about whether the Eurozone is taking the right steps to solve the crisis and get Europe back on the path to growth.

Economic data during the quarter also gave the market reasons to worry. There weren't signs that the U.S. economy was completely collapsing, but there also weren't any clear signs that the economy was retuning to robust growth. The economy remains stuck in neutral. Job growth is anemic, at best, the housing market remains stuck in the basement, and manufacturing data showed some weakness as well in the quarter. On the other hand, consumer spending remained surprisingly resilient, and inflation stayed largely in check.

Corporations continued to report decent earnings in the quarter. Belt-tightening during the peak of the recession and exposure to emerging markets left firms with lean cost structures and kept profitability high even in the face of relatively weak U.S. demand.

As we turn to the fourth quarter, the pressure points that emerged in the third quarter will still be in focus. We expect the next three months will be filled with plenty of drama surrounding the Eurozone and how to fix the finances of the United States. The real question is what impact these debates will have on investors.